E-piphany

The G-7 finance minister/central banker call came and went today with no earth-shattering announcement. In a statement, the U.S. Treasury Department said:

The G-7 ministers and governors reviewed developments in the global economy and financial markets and the policy response under consideration, including the progress towards financial and fiscal union in Europe.

That isn’t the bombshell that some had been expecting. But there’s always the ECB’s meeting tomorrow! It is also a rare “Venus transit” of the sun, so you never know. According to that awesome repository of pure truth, the Internet, “…in general, the transit of Venus bodes well—it’s a good time to fall in love, find favorable resolution in a pending court case, or catch a much-needed break.” That’s welcome news, because Europe sure could use a break! Weirdly, few institutional economists are forecasting a rate cut from Draghi. I would be flabbergasted if the ECB did not cut rates, at least, and I wouldn’t be shocked at further policy measures although they’ll probably hold off on those until Greece actually exits the Euro.

Fed Chairman Bernanke is testifying on Thursday before Congress about the economic outlook. Between the post-ECB presser and the Bernanke testimony, I suspect we will know a lot more about how bankers are looking at the current economic environment by the time Friday rolls around. My suspicion is that they will sound a lot more dovish than they did just a month or two ago. A rotten Employment report in the largest economy and consistently bad PMI reports in the top two economies (U.S. and Europe), along with a rapidly-developing sovereign/banking crisis, will tend to do that.

Those things will also tend to dampen inflation expectations. Whatever your belief about core inflation, recessions tend to produce declines in energy prices and a consequent slowdown in headline inflation (which is what TIPS and inflation swaps are indexed to). Market prices make clear there is currently expectations of a near-term decline in the rate of increase, or even an outright fall, in headline prices. A reader sent me a link to this interesting blog where the author discusses the recent inversion of the TIPS curve. The inversion makes the recent decline in short-term inflation expectations look a lot more dramatic than it is (because short TIPS behave like gasoline futures more than bonds, essentially), but the decline in near-term inflation expectations has certainly happened. The chart below (Source: Enduring Investments) shows the inflation swaps curve currently, compared to the curve one month ago and one year ago. That’s a dramatic elbow in the curve!

And the “elbow” has been growing more pointed. Over the last month the 1-year inflation swap has dropped some 85 basis points, and since the March highs it has fallen 180 bps. However, the chart below (Source: Enduring Investments) shows that almost all of this was due to changes in energy inflation expectations. On May 29^th, the core inflation implied by the 1-year swap (which was at 1.31%) was 2.16%, only about 18bps below what had been implied on March 13^th. Over the last week, however, expectations for next year’s core inflation have fallen from 2.16% to 1.86%, accounting for about 70% of the decline in the 1-year zero-coupon inflation swap rate over that week. That is an actual meaningful sea change in the attitudes of inflation investors.

It does bear noting, though, that it is only a sea-change in near-term inflation expectations. The zero coupon inflation curve prices headline inflation over the next 12 months at 0.88%; for the next 12 months (1y, 1y forward) at 1.47%; for the 1y, 2-years forward at 2.21%; and for the 1y, 3-years forward 2.66%. As the chart below (Source: Enduring Investments) illustrates, investors are none-too-sanguine about inflation after whatever near-term correction they think is coming.

Let’s talk a bit about that correction. John Mauldin wrote recently that both deflation and inflation are coming, it’s just that the timing is uncertain. I agree with the part about the timing, but I am skeptical about the deflation.

Arguments in favor of the looming deflationary spiral, precipitating from the European implosion, must lean on expectations for a decline in the velocity of money. Recessions do not naturally cause disinflation. I’ve shown the chart below (Source: Bloomberg) before, but it is worth showing over and over! It shows real GDP (level) in 2005 dollars in white, versus the core CPI price index, in yellow, normalized to 12/31/1999=100. The upshot is that we’ve just come off the biggest recession in 80 years, and inflation barely slowed. In fact, if you remove the effects of the bubble unwind in housing, it didn’t slow at all. If growth causes inflation, and if recessions are by definition deflationary, then we should have seen a decline in core prices.

Now I agree that there’s likely a recession coming, most likely to the U.S. as well as Europe and perhaps globally. But I don’t agree that such a thing is necessarily deflationary.

However, as I said above one can rely on a money velocity argument in this case and Mauldin adeptly does so. I’ve demonstrated previously (for example, here) that money velocity is reasonably well-correlated to changes in the provision of bank credit. The updated chart from that article is below (Source: Enduring Investments), and if the quarter ended today the 2-year compounded rise in commercial bank credit would be up around 2.5%, implying that something like a 17% increase in velocity is expected (eyeballing from the chart).

This does suggest a possibility, though, and a way that deflationists could be right. If commercial bank credit collapsed again, then I would expect velocity to keep on contracting. My argument about the upside risks to inflation – at least, the long-tail possibilities – depends on a rebound in money velocity that is not countered by aggressive tightening. We are not going to get aggressive tightening, certainly. But there is a possibility that credit could seize again, as it did in late 2008. Certainly, this is a reasonably likely outcome with European banks. The question is whether U.S. banks – which are much healthier now and currently increasing lending at a 6% clip versus 52 weeks ago – Canadian banks, Japanese banks, etcetera could pick up enough of the slack (or whether European regulators would allow or even encourage zombie banks to keep lending once they become effectively wards of the state) to offset this.

If policymakers get any inkling that credit is seizing up, then the monetary spigots will open wide once more, so in my view a deflationary outcome is very unlikely. But in fairness such a downside tail is more of a possibility than it was a year ago. Is it possible that central bankers might stand down even as velocity plunges? It’s possible, now that there is some concern about the sizes of central bank balance sheets – but I don’t think it’s very likely. So in my opinion, the possible downside “deflation” tail is short in length, short in duration, and low in likelihood; the possible upside “inflation” tail is quite long, quite long in duration, and not nearly as unlikely…in a world where monetary tightening is not viewed as feasible.

I’ll go further and say that if I had to hazard a guess, I would guess that five years from now, we will giggle when we think back and recall that we were concerned about whether our “entry point” for long-inflation trades was 2.10% or 2.40% on ten-year inflation.